Legg Mason - "Assessing the Gorilla"

Aktueller Original - Kommentar von der US Investmentbank Legg Mason :

Equity Mutual Funds: Assessing The Gorilla

The Investment Company Institute's (ICI) release of equity mutual fund data for the month of July is noteworthy in reporting the largest net outflow of assets in history.1 Stock funds had an outflow (net redemptions minus net new sales) of $52.63 billion, or 1.7% of previous month-end assets. While the dollar amount of the outflow was the largest ever, the percentage of outflow/assets was still well below October 1987's record of 3.17%. For the year, equity funds are clinging to a net inflow in assets of $466 million, a pace lower than 2001's total of $32 billion and a pittance compared to 2000's record of $309 billion. There have not been two consecutive years of declining inflows since 1988, which was also the last time there were net outflows for the full year. Despite the negative flow, the S&P 500 rose 12% in 1988.

The outflow of stock assets is migrating to bonds and money market funds. Bond funds had a record inflow of assets ($28.1 billion). Money market assets increased by $54.6 billion, even though yields dropped to all-time low of 1.0%. The ratio of money market assets to stock funds rose to 81%, which is the highest since 1992. In 1999, the ratio of money market assets to stock funds was 40%.2

While the slowdown of inflows is coincident with the negative returns in stocks, there is also a question of the influence mutual funds are having on stock market performance. Mutual funds are now the largest class of institutional ownership and depending on how one sizes the U.S. equity market, account for approximately 19%-22% of its value, which is three times higher than was the case in 1988 (6.1%).3 The availability of retirement vehicles and individual investors' preference for the convenience, diversification, and professional management of equity assets have facilitated growth in equity funds that far surpasses that of any other owner category of stocks. Direct ownership of stocks by individuals has been declining steadily, from over 70% in 1970 to an estimated 38% in the first quarter of 2002.4

Institutions and the Investment Process
The "institutionalizing" of the stock market has provided benefits in creating innovative financial products (i.e., derivatives) as well as technology for reducing trading costs, and in increasing the liquidity of the market. Mutual funds have been the catalyst for these changes, with the introduction of over 3,500 new stock funds in the last 10 years. There are now approximately 4,800 open-end stock funds. The combined average daily trading volume for the NYSE, AMEX, and NASDAQ has increased almost tenfold in the last 10 years.5

The institutional impact also has affected the investment process, particularly with regard to mutual funds. The wide availability of performance analysis and low switching costs have increased investors' desire to position assets for maximum return. Redemption activity for mutual funds with a long-term objective (includes bond funds) has gone from 6% of net assets in 1970 to 26% in 2000. Consultants and advisory services, increasingly the source in helping investors decide among the fund alternatives, parse and quantify performance to an appropriate benchmark, such as the S&P 500. The benchmark is often a passive and lower-cost alternative to an active portfolio manager. The debate over active versus passive investing is spirited, with each side presenting defendable arguments. Passive investing was very popular when it was outperforming most active managers in the last several years of the bull market (1998-2000). In 1998, Standard & Poor's estimated that over $1 trillion of equity assets were indexed directly to various S&P indices (primarily the S&P 500). Given that active portfolio managers have been outperforming benchmarks in the bear market, the push for indexing probably has cooled.

Institutional ownership has forced the investment process to become more systematic, compartmentalized, and commoditized. The realties of a competitive marketplace focus portfolio managers on the benchmark by which they are judged and not necessarily the investment objective of the fund's prospectus. The shift towards relative benchmark focus is reflected in changes in how portfolio managers treat cash assets. Prior to 1996, the cash assets in equity funds averaged about 9%, rarely dropped below 7%, and reached a 35-year high of 13% in 1990. The ratio dropped below 5% in the halcyon years of strong inflows when cash was a drag on performance and inflows were so strong. But despite a 28-month bear market, the longest in over 50 years, the ratio reported in July 2002 was 4.6%, which is not far from the 4% all-time low in 2000. The low cash ratio would normally be viewed as bearish, particularly given the large net outflows over the last several months.

The low cash ratio has several explanations. First, the relative-to-the-benchmark standard does not reward portfolio managers for holding cash. The risk of having too much cash if the market rises more than offsets the performance advantage of having cash for defensive purposes. The benchmark does not earmark a cash allocation in its performance calculation. While an argument is made that portfolio managers are being opportunistic now with lower equity prices, 5% is the average for the last five years (range of 4%-6%). In other words, portfolio managers were not prescient at the market peak in terms of building cash and they are not necessarily more bullish now. Rather, 5% is the level that is believed to be sufficient for potential net redemptions and to maintain the flexibility of keeping the portfolio invested.

There are also several assumptions that accompany the 5% cash level. The most significant is the predictability of investor behavior. ICI has developed a statistical forecast model, based on monthly correlation data of inflows (net sales), outflows (redemptions), and market performance (Wilshire 5000) that has been remarkably accurate over the last several years.6 As noted with the July data, it takes a significantly negative market to cause net outflows to exceed 1.0% of assets. In the market decline of September 2001, outflows accounted for 0.89% of assets. While redemptions increase in a declining market, other investors view lower equity prices opportunistically. In July 2002, redemptions totaled $151.5 billion or 4.9% of equity assets, but there were new additions of $98.9 billion (3.2%). Interesting enough, the largest month for gross redemptions was at the market peak in March 2000, when withdrawals amounted to $202 billion or 5.1% of assets. With investor behavior becoming more predictable in terms of sales and redemptions, the need for holding excess cash becomes less.

The other factor supporting lower cash levels is the recurring nature of inflows from retirement plans, primarily from defined contribution and IRAs. In 2001, net new cash to equity mutual funds from these sources amounted to $60 billion.7 However, this amount was less than one-half of the previous two years' inflow.

Assessing The Risks
The low cash ratio in equity funds, while perhaps optimizing a portfolio for performance versus a fully invested benchmark, has risks for the equity market. There is less of a cushion to absorb spikes in redemptions or a change in investment behavior from what is predicted. Stock funds will have to be sensitive to shorter-term market declines and represent the marginal seller pushing prices lower. The difference now is that mutual funds are so much larger than they were. Perhaps the biggest risk is investor attitude toward equity mutual funds. The S&P 500 has produced a compounded five-year annual return of 1.7% (dividends reinvested) through August 30, 2002, and there are many funds that performed worse. If investors begin to believe that fund managers are not sensitive to absolute risk and return, they may allocate elsewhere.

The evolution of equity mutual fund investing has been a success story for U.S. capital markets and investors alike. The institutional changes were as inevitable as are the greater investor scrutiny and impatience for performance. If there is a disconnect, it lies with the differences between an emerging absolute standard of performance by individual investors and the relative return to benchmark focus of mutual fund portfolio managers. Individuals have the responsibility for recognizing the performance conundrum in the marketplace. For active portfolio managers, the many strategies that are employed must be oriented to growing wealth consistent with a degree of prudence that goes beyond index-matching performance.

Richard E. Cripps, CFA
Chief Market Strategist